Working Paper No. 04-36:
The Entrepreneurship Effect: An Accidental Externality in the Federal Income Tax

Author(s):

Abstract:

Case law and commentators often speak as if all income-producing activities are taxed similarly. However, that simply is not true for individuals. Although the expenses and losses of business activities generally are deductible from income of any source and net losses can be carried to other tax years, individuals= investment expenses and losses generally are deductible only from investment income. This systematic distinction between the two types of profit-seeking activities apparently is accidental; many of the provisions disallowing investment-related deductions were enacted at different times, and each one has its own rationale. Yet, the combined effect of these provisions on individual investors is a systematic preference for business losses over investment losses.

Economists have shown that a tax system that allows full deduction of the losses from an activity effectively shifts part of the risk of that activity to the government. This, in turn, allows the investor to increase investment in that activity without increasing his risk. In other words, the deductibility of a net loss from an activity provides a subsidy for that activity. Federal income tax law therefore implicitly subsidizes entrepreneurship by individuals.

The implicit subsidy for entrepreneurship is strongest for high-income individuals, for a number of reasons, including the progressivity of the federal income tax. That is, given progressive marginal income tax rates, taxpayers with significant income from other sources benefit most from the deduction of losses. In addition, as the article shows, despite progressive taxation, high-income individuals are not disproportionately taxed if the business is successful. In fact, high-income individuals obtain the largest benefit from techniques, such as incorporating the business, that lower the effective tax rate applied to a successful business. These insights highlight the importance of considering tax changes in a larger context. For example, as discussed in the article, lowering individual income tax rates may actually decrease entrepreneurship by individuals. The recently reduced tax rate on dividends received by individuals may have the same effect because it subsidizes investments in the corporate form regardless of whether the individual=s investment is a safer passive one or a riskier investment in a business that the individual actively manages.